Chapter 1

Opening the Cornucopia of Reports

IN THIS CHAPTER

Reviewing the importance of financial reports

Exploring the different types of financial reporting

Discovering the key financial statements

Financial reports give a snapshot of a company's value at the end of a particular period, as well as a view of the company's operations and whether it made a profit. The business world couldn't function without financial reports. Yes, fewer scandals would be exposed because companies wouldn't be tempted to paint false but pretty financial pictures, but you'd still need a way to gauge a firm's financial health.

Currently, nothing's available that can possibly replace financial reports. Nothing can be substituted that'd give investors, financial institutions, and government agencies the information they need to make decisions about a company. And without financial reports, the folks who work for a company wouldn't know how to make it more efficient and profitable because they wouldn't have a summary of its financial activities during previous business periods. These financial summaries help companies look at their successes and failures and make plans for future improvements.

This chapter introduces you to the many facets of financial reports and shows you how internal and external players use them to evaluate a company's financial health.

Figuring Out Financial Reporting

Financial reporting gives readers a summary of what happens in a company based purely on the numbers. The numbers that tell the tale include the following:

• Assets: The cash, marketable securities, buildings, land, tools, equipment, vehicles, copyrights, patents, and any other items needed to run a business that a company holds
• Liabilities: Money a company owes to outsiders, such as loans, bonds, and unpaid bills
• Equity: Money invested in the company
• Sales: Products or services that customers purchase
• Costs and expenses: Money spent to operate a business, such as expenditures for production, compensation for employees, operation of buildings and factories, or supplies to run the offices
• Profit or loss: The amount of money a company earns or loses
• Cash flow: The amount of money that flows into and out of a business during the time period being reported

Without financial reporting, you'd have no idea where a company stands financially. Sure, you'd know how much money the business has in its bank accounts, but you wouldn't know how much is still due to come in from customers, how much inventory is being held in the warehouse and on the shelf, how much the firm owes, or even how much the firm owns. As an investor, if you don't know these details, you can't possibly make an objective decision about whether the company is making money and whether investing in the company's future is worthwhile.

Preparing the reports

A company's accounting department is the key source of its financial reports. This department is responsible for monitoring the numbers and putting together the reports. The numbers are the products of a process called double-entry accounting, which requires a company to record resources and the assets it uses to get those resources. For example, if you buy a chair, you must spend another asset, such as cash. An entry in the double-entry accounting system shows both sides of that transaction - the cash account is reduced by the chair's price, and the furniture account value is increased by the chair's price.

This crucial method of accounting gives companies the ability to record and track business activity in a standardized way. Accounting methods are constantly updated to reflect the business environment as financial transactions become more complex. To find out more about double-entry accounting, turn to Chapter 4.

Seeing why financial reporting counts (and who's counting)

Many people count on the information companies present in financial reports. Here are some key groups of readers and why they need accurate information:

• Executives and managers: They need information to know how well the company is doing financially and to find out about problem areas so they can make changes to improve the company's performance.

• Employees: They need to know how well they're meeting or exceeding their goals and where they need to improve. For example, if a salesperson has to make $50,000 in sales during the month, they need a financial report at the end of the month to gauge how well they did in meeting that goal. If they believe that they met the goal but the financial report doesn't show that they did, they must provide details to defend their production levels. Most salespeople are paid according to their sales production. Without financial reports, they'd have no idea what their compensation is based on.

  Employees also make career and retirement investment decisions based on the company's financial reports. If the reports are misleading or false, employees may lose most, if not all, of their 401(k) retirement savings, and their long-term financial futures may be at risk.

• Creditors: They need to understand a company's financial results to determine whether to risk lending more money to the company and to find out whether the firm is meeting the minimum requirements of any loan programs that are already in place. To find out how creditors gauge whether a business meets their requirements, see Chapters 9 and 12.

  If a firm's financial reports are false or misleading, creditors may loan money at an interest rate that doesn't truly reflect the risks they're taking. And by trusting the misleading information, they may miss out on a better opportunity.

• Investors: They need information to judge whether a company is a good investment. If investors think that a company is on a growth path because of the financial information it reports, but those reports turn out to be false, investors can pay, big time. They may buy stock at inflated prices and risk the loss of capital as the truth comes out, or they may miss out on better investing opportunities.
• Government agencies: These agencies need to be sure that companies comply with regulations set at the state and federal levels. They also need to be certain that companies accurately inform the public about their financial position.
• Analysts: They need information to develop analytical reviews for clients who are considering the company for investments or additional loan funds.
• Financial reporters: They need to provide accurate coverage of a company's operations to the general public, which helps make investors aware of the critical financial issues facing the company and any changes the company makes in its operations.
• Competitors: Every company's bigwigs read their competitors' financial reports. If these reports are based on false numbers, the financial playing field gets distorted. A well-run company could make a bad decision to keep up with the false numbers of a competitor and end up reducing its own profitability.

Companies don't produce financial reports only for public consumption. Many financial reports are prepared for internal use only. These internal reports help managers accomplish these tasks:

• Find out which of the business's operations are producing a profit and which are operating at a loss
• Determine which departments or divisions need to receive additional resources to encourage growth
• Identify unsuccessful departments or divisions and make needed changes to turn around the troubled section or kill the project
• Determine staffing and inventory levels needed to respond to customer demand
• Review customer accounts to identify slow-paying or nonpaying customers, to devise collection methods and develop guidelines for when a customer should be cut off from future orders
• Prepare production schedules and review production levels

This list identifies just a few of the many uses companies have for their internal financial reports. The actual list is endless and is limited only by the imagination of the executives and managers who want to find ways to use the numbers to make business decisions. I talk more about using internal reports to optimize results in Chapters 14 and 15.

Checking Out Types of Reporting

Not every company needs to prepare financial statements, but any company seeking to raise cash through stock sales or by borrowing funds certainly does. How public these statements must be depends on the business's structure.

Most businesses are private companies, which share these statements only with a small group of stakeholders: managers, investors, suppliers, vendors, and the financial institutions that they do business with. As long as a company doesn't sell shares of stock to the general public, it doesn't have to make its financial statements public. I talk more about the reporting rules for private companies in Chapter 2.

Public companies, which sell stock on the open market, must file a series of reports with the Securities and Exchange Commission (SEC) each year if they have at least 500 investors or at least $10 million in assets. Smaller companies that...